Wednesday, April 14, 2010

Shoddy construction throughout the world, but especially in China and the U.S., is a type of malinvestment, and it will have consequences.

Everybody seems to know about China's real estate bubble and brand new empty cities, but few seem to understand that maintenance is essentially non-existent.

Build it new, and when it gets "old" (say, 20 years), then tear it down and rebuild it in grand style. That has been the Chinese mindset since the Great Transformation launched in 1978 ("To get rich is glorious").

But when real estate development becomes half of the economy, and literally thousands of highrise buildings have been thrown up, along with glitzy malls, U.S.-style suburban develpments, grand civic plazas, etc., then at some point there won't be enough money in the Universe to tear them all down and rebuild them in a yet grander fashion.

If you have spent some time in China, then you already know building maintenance is not a priority, a recognized trade or even a concept which has a toehold in the mindshare of frenzied development and the pursuit of glorious riches.

Here is the U.S., a similar frenzy of get-rich-quick construction took hold in the bubble decade 2000-2007, and tens of thousands of McMansions were tossed together by inexperienced builders and crews. While the defective Chinese drywall installed in thousands of homes has recently made headlines, that is merely the tip of the iceberg in terms of defective, shoddy construction put in place in the go-go housing bubble years.

Here is a rare bit of unvarnished reporting on China's shoddy construction, from a China Daily interview with a Big Nose (Westerner) bigshot in Beijing:

I think people in China, for obvious reasons, don't often think long term. People are more worried about things that may happen tomorrow or in the next two or three years, than they are about what may happen in 50 years. But at some stage in the future, people will start to think more about the long term.

The quickly built but cheaply made buildings in Beijing will not literally fall down, but will deteriorate. Wall paint will peel and elevators won't work. Buildings will become uncomfortable because they will not have been properly maintained. That's when people will start to realize they've paid a lot of money to buy a place in the Central Business District and they've paid management charges, but nothing works and everything looks really poor. But the developers will probably be long gone by then, so I'm not sure what people will do.

Many buildings in Beijing are built with the cheapest materials available, which tend to degrade quickly. This is a worryingly common phenomenon. There are many buildings here that appear as if they are 10 or 15 years old, but are really just five years old. That's a little bit sad.

I have a 75-year-old apartment in New York, but it's still in great condition. You don't see that here. Fast and cheaply built apartment complexes dominate the property market here and there will be future consequences for this. And it might be apartment owners who end up paying them.

The apartment owners won't have any money to do so because they make $8,000 a year and paid $200,000 for their apartment. Here is Jim Chanos in BusinessWeek:

They (China's leadership) are on this treadmill to hell because 50% to 60% of GDP is construction. And if they stop construction, you'll see GDP growth go negative quickly. That's not going to happen because in China, people are rewarded at almost every level of government for making their economic growth numbers. The easiest way to do this: put up another building. So they're really hooked on this sort of heroin of real estate development.

The perception seems to be that China will grow out of this situation. But the problem with that argument is the real estate being built is not for the masses. This is not affordable housing for the middle class. This is high-end condos in major urban areas and high-end office buildings. Just to give you an idea, right now construction costs in China are starting to hit $100 to $150 per square foot in some cities. That doesn't sound like a lot by Western standards, but it means a condominium basically presented to you with no floors, no walls, no appliances costs the average Chinese two-income couple $100,000 to $150,000 U.S. That Chinese two-income couple in their 30s probably makes combined $7,000 or $8,000 a year. You do the math. Even if they were making $10,000 to $15,000 a year, they couldn't carry a $150,000 condo. This is very similar to someone making $40,000 in the U.S. at the height of our bubble buying a $600,000 or $800,000 house. We know how that ended.

You get rough concrete walls for your $150,000--no finished walls, no plumbing except stub-outs, no wiring except the panel box, no interior walls, and concrete floors. Even in China, where labor is still quite cheap, constructing your dwelling will cost a lot of money--$50,000 is a good ballpark number but it would be easy to spend more.

So the apartment costs 25 times the household's gross income. For a U.S. household making $40,000 a year, that is the equivalent of buying a $1 million condo.

The folly is always based on the same premise: the government will never let real estate fall in value. Indeed, a collapse in price is impossible.

Unfortunately, the homeowners could build a beautiful, lavishly appointed home in their new highrise and find that the elevators no longer work in a few years. There are "homeowners' associations" in these buildings but the fees are too modest to handle costly repairs like new roofing, exterior painting or elevator repair.

Here in the U.S., few understand that defective construction is extremely expensive to fix. Quickly built McMansions are primarily at risk of water damage from leaky flashing, windows, etc. Once water seeps in, then mold starts growing inside the walls, floors peel up, drywall crumbles, etc.

Big builders have learned how to game the U.S. legal system to evade responsibility for defective construction--please see homeowners against deficient dwellings (HADD) for more on this and related issues. And of course, going bankrupt and disappearing always works, too.

Shelter is not the same as speculation. In the rush to get rich quick, the two have been seen as identical throughout the world. Speculation is a mindset, a frenzy of greed, numbers in an account, "the stuff dreams are made of;" shelter is a physical reality, an assemblage of materials in the tangible world which require care in assembly and in maintenance.

The difference between financial speculation and buildings will become ever more apparent in the coming decades as buildings built on the sands of speculations fall apart.

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